I’ve been a shareholder of Algonquin Power & Utilities Corp. (AQN-T) for more than a decade, and it’s been a terrific investment until now. Thanks to a combination of organic growth and profitable acquisitions, the renewable power producer and utility operator has steadily increased its asset base, earnings and dividends, rewarding shareholders with double-digit total returns.
That all changed on Nov. 11, when Algonquin posted third-quarter results below expectations, cut its 2022 earnings forecast and warned that its long-term growth targets are in doubt. The stock has cratered more than 30 per cent since then, and investors are bracing for a potential dividend cut.
Readers have asked for my opinion on Algonquin, and today I’ll share some thoughts. I’ll start by saying that the earnings release blindsided not just investors but also analysts, whose research notes in recent months largely depicted a company that was still on a steady course. In hindsight, one of the few potential clues was the resignation, on Aug. 30, of Algonquin’s chief financial officer, a development that drew little notice at the time but which may have been a red flag.
Dividend in doubt – so I’m (partly) out
Markets hate uncertainty, and Algonquin hasn’t helped by making investors wait until its investor day some time in early 2023 to clarify how it intends to get out of its financial predicament.
One thing is clear: Algonquin’s days as dividend growth darling are over. With the stock’s decline pushing the yield to about 9.4 per cent, analysts expect Algonquin to chop its payout by 25 to 50 per cent to give the company some financial breathing room.
As Algonquin no longer meets the criteria for inclusion in my model Yield Hog Dividend Growth Portfolio, this week I “sold” all 485 shares in the portfolio. I also sold a portion of my Algonquin shares personally, partly for the tax loss, but I remain a shareholder of the company.
Rising rates are hitting hard
Algonquin said three factors contributed to its reduced 2022 guidance: Sharply rising interest rates, delays affecting certain renewable energy projects (and the tax credits that come with them), and the California Utilities Commission’s decision to push a rate-case decision for Algonquin’s CalPeco Electric subsidiary into 2023.
Of the three, high interest rates likely pose the biggest threat. As of Sept. 30, for every one-percentage-point increase in rates, interest costs on Algonquin’s debt – about 22 per cent of which is currently subject to floating rates – would rise by about $16.7-million. Worse, Algonquin’s variable-rate debt is set to roughly double to about US$3.3-billion with the expected closing of its Kentucky Power Co. acquisition in January. “At this level, we estimate that a 1-per-cent increase in interest rates would increase financing costs by $33-million” annually, Nelson Ng, an analyst with RBC Dominion Securities, said in a note.
Why didn’t Algonquin hedge its floating debt against rising rates? As the company explained in its third-quarter management discussion and analysis: “Borrowings subject to variable interest rates can vary significantly from month to month, quarter to quarter and year to year. AQN does not currently hedge the interest rate risk on its variable interest rate borrowings due to the primarily short term and revolving nature of the amounts drawn.”
When interest rates or other costs rise, utilities can ask permission from the regulator to raise rates charged to customers. But the process takes time – it’s known as “regulatory lag” – and regulators might be less inclined to approve utility rate increases in a challenging economic environment when consumers are already having trouble making ends meet.
Payout ratio problems
Is a dividend cut inevitable? No, at least in theory. With soaring interest costs taking a bite out of Algonquin’s bottom line, analysts expect its payout ratio will exceed 100 per cent of earnings in 2022 and 2023 – well above the company’s own target payout of 80 to 90 per cent.
But because earnings are reduced by accounting items such as depreciation that don’t affect a company’s cash flow, Algonquin could conceivably pay out more than 100 per cent of earnings for a few years and gradually “grow into” its target payout ratio, Ben Pham, an analyst with BMO Capital Markets, said in a note. However, given the soaring cost of debt and Algonquin’s muted earnings outlook, the board of directors might balk at such an approach, he said.
Credit rating in focus
Moreover, debt-rating agencies might not be comfortable with Algonquin maintaining its dividend at current levels, given that the company’s credit metrics could be stretched. Standard & Poor’s rates Algonquin’s debt at BBB with a negative outlook and warned in March that it could lower the rating “if the company experiences material adverse regulatory requirements relative to the KPCo [Kentucky Power] acquisition or if the funding for elevated capital expenditures including the acquisition of KPCo diverges materially from the current expectation …”
A single-notch downgrade by S&P would drop Algonquin’s credit rating to BBB-minus, which is the lowest rung of investment grade. As a utility operator and renewable power producer with large financing needs, the last thing Algonquin can afford is to lose its investment grade rating and see its borrowing costs rise even further.
In an open letter to shareholders on Thursday night, Algonquin president and chief executive officer Arun Banskota stressed the importance of maintaining its credit rating: “Algonquin remains focused on driving sustainable long-term profitable growth that supports an investment grade credit rating. Our dividend is an important component of our total shareholder return. We strive to provide a strong and sustainable dividend to our shareholders.”
It’s worth noting that the sentence about maintaining Algonquin’s credit rating was in bold, whereas the sentences about the dividend were in plain type and did not rule out a dividend reduction. Mr. Banskota added that he purchased 131,000 Algonquin shares this week (for a total cost of more than $1.5-million, according to insider trading records) and said other directors “similarly put their own money behind their conviction in Algonquin.”
More asset sales, less growth
Algonquin has other levers it could pull to raise cash. In October, the company announced the sale of a 49-per-cent interest in three U.S. wind facilities for about US$278-million and an 80-per-cent stake in a Canadian wind farm for $107-million. The company is exploring further “asset recycling” opportunities. Analysts expect the company will also announce it will scale back its growth and capital spending plans at its investor day.
A dividend cut would not be the end of the world for Algonquin. As much as it would disappoint some income-focused investors, reducing the payout is the most prudent course for the long-term health of the company. Paying investors close to 10 per cent makes no sense for a company struggling to fund its own business. Instead, Algonquin should focus on fixing two things: its stretched finances, and investors’ broken trust.
E-mail your questions to jheinzl@globeandmail.com. I’m not able to respond personally to e-mails but I choose certain questions to answer in my column.
Special to The Globe and Mail
John Heinzl